Learn to move beyond the noise and reclaim the concept of financial innovation. Throughout history, advances in financing have expanded opportunities and democratized societies, and their potential is still ready to be grasped today.

This chapter is from the book

It was a perfect storm. Beginning in 2007, a cascade of extreme events rocked the global financial system, outstripping the risks imagined by central bankers, financial professionals, and policymakers. Within a year's time, international stock market declines had destroyed trillions of dollars in wealth. In the wake of the housing meltdown and the ensuing "Great Recession," pension systems remain fragile and household balance sheets are a wreck.

A confusing alphabet soup of acronyms (think CDOs squared, then cubed, and stuffed with SIVs, CMOs, CLOs, and CDSs) dominated the headlines. With their leverage levels on steroids, many financial institutions and firms had gorged on these overly complex products. The press was aghast to learn that some CEOs didn't have a grasp on the convoluted products on which their traders had placed staggering bets.

The financial crisis of 2007–2009 brought many chickens home to roost in global capital markets. Some $9 trillion of assets in the United States alone had been securitized. By fall 2008, lower-grade securities had been reworked into roughly a half-trillion dollars' worth of long-term capital instruments (through collateralized debt obligations) and $1.2 trillion of short-term money market instruments (through asset-backed commercial paper and structured investment vehicles). These were underwritten by almost $800 billion of private mortgage insurance, issued by bond insurers that ultimately backed a total of more than $2 trillion of debt. The whole conflict-ridden system was hedged in a murky $45 trillion credit default swap market—a fine mess, indeed. When the underlying asset bubbles began to implode, liquidity froze and markets cratered.1

Fear and loathing of Wall Street is once again loose in the land, but precious little analysis has been offered to distinguish genuine innovation from the churning out of copycat devices designed to conceal the shakiness of the underlying assets, and far too prone to exacerbating systemic risk. The long and storied tradition of real financial innovation—the drive to build new tools that increase clarity in valuation and promote capital formation for productive enterprises—was co-opted during the bubble years, perverted into schemes meant to obfuscate and create opacity in asset pricing.

The purpose of this book is to move beyond the noise and reclaim the concept of financial innovation. Throughout history, advances in financing have expanded opportunities and democratized societies—and their potential is still ready to be grasped today. If the right tools are deployed responsibly, financial innovations have the capacity to help us shape a more sustainable and prosperous future.

Finance, at its core, is the catalyst for launching productive ventures and the most effective tool for managing economic risks. Today that process takes place with split-second global transactions and cutting-edge software, but the essential concepts of finance are timeless and rooted in antiquity.

To fully grasp the underpinnings of modern finance, it is useful to note the seminal—and ever more sophisticated—innovations that have marked its evolution, whether it was the first use of credit in Assyria, Babylon, and Egypt more than 3,000 years ago, or the introduction of the bill of exchange in the fourteenth century.2 Many of these advances democratized economic participation, such as when consumer credit took hold in the 1700s. (By the early part of the twentieth century, tallymen were hawking clothes in return for small weekly payments.3) Home mortgages, the founding of stock markets and exchanges, and the wider availability of farm and small-business credit and investment followed in turn.

Financial innovation not only threw open the door to a vast expansion of land, home, and business ownership—broadening prosperity in ways that were unimaginable in earlier centuries—but it also eventually devised ways to value intellectual property. That ability to transform ideas into new industries dramatically quickened the pace of change. By the mid-1980s, Nobel laureate Merton Miller correctly noted, "The word revolution is entirely appropriate for describing the changes in financial institutions and instruments that have occurred in the past 20 years."4

Multiple studies have documented the positive and profound effects of consumer and business finance on economic growth. Any country that forgoes the building of deep, broad financial institutions and markets is also likely to forgo growth. Cross-country comparisons show that nations with higher levels of market development experience faster aggregate growth and smaller income gaps with the wealthiest nations. Recent empirical estimates suggest that if emerging nations doubled bank credit to the private sector as a percent of gross domestic product (GDP), they could increase annual GDP growth by almost 3%. Doubling the trading volume in their securities markets would increase GDP growth by 2%.5

At its best, finance can be used to balance the interests of producers, consumers, owners, managers, employees, investors, and creditors. At the risk of stating the obvious, these disparate actors on the economic stage often fail to get along, for a whole host of reasons. When they don't, economic value is destroyed, business plans are laid to waste, new technologies and ideas wither on the vine, and scarcity—the ultimate bane that economics seeks to overcome—prevails.

The purpose of finance, carried out with technology and sometimes a dash of art, is to create a capital structure that aligns the cooperating and sometimes conflicting interests within an enterprise—whether private, public, government, or nonprofit—toward a common objective. Finance mediates among these interests, addressing the frictions and risks inherent in transactions.

It is through the design and construction of a capital structure that a public or private enterprise finances its assets and leverages them into a greater flow of productivity, innovation, and enterprise. Capital structure is the way a firm, household, enterprise, or project (even those involving partnerships of public and private actors) allocates its liabilities through debt, equity, and hybrid instruments. These operating and investment decisions affect the value of any good or service that is produced.

The cash flow through an enterprise is as vital to its survival as oxygen. It must be distributed based on various claims from creditors, owners, employees, and so forth. Capital structure allocates shares of that cash flow pie and seeks to grow it. Finance seeks to optimize the sustainability of cash flow, creating positive feedback loops among all the relevant players. Financial frameworks can serve as both carrot and stick, creating incentive structures that maintain an enterprise and enable it to grow.

As Bradford Cornell and Alan Shapiro have demonstrated, financial innovations and business policies can increase the value of an individual firm through the complex web of contracts that binds investors, management, employees, customers, suppliers, and distributors. Strengthening relations with noninvestor stakeholders through management and employee incentives, increasing the confidence of suppliers and customers, and linking public and private interests can increase the value of an enterprise.6

Innovation can also be used to resolve information asymmetries—that is, the situation in which some market participants have information that others do not, thereby making markets inefficient and costly to all. Information asymmetries are a core challenge in finance, increasing the risk of unknowns and uncertainties in any transaction, especially those concerning interest rates. Finance assigns costs to the risks of undisclosed information that might eventually emerge. In bridging these gaps between parties, their claims on the cash flows from any enterprise can be assigned, priced, packaged into a financial product, and exchanged.

Finance is more than simply a method of allocating capital. When harnessed correctly, it has the capacity to drive social, economic, and environmental change, transforming ideas into new technologies, industries, and jobs.

Overcoming the remaining gaps in capital access and sound market structure represents the challenge and opportunity of our age. We can understand and resolve an array of urgent global problems—financial crises, environmental degradation, world hunger, post-conflict reconstruction, housing, and disease—if we carefully analyze them through the lens of finance.

The Language of Finance

Finance emerged as a social construct from the way people gave voice to their day-to-day economic interests, defined them, and sought to measure and manage them in real markets. In many cases, the words they devised live on in common usage today, underlining the fact that, despite its sophisticated high-tech profile, the fundamental role of finance remains much the same as it ever was.

One way to understand finance at its most elemental level is to walk through an example of how a social unit becomes sustainable, a process Figure 1.1 illustrates. Imagine any basic unit of social organization: a family, a household, a community, a business, a nonprofit, or a project. Common to all is the necessity of enterprise—that is, undertaking activities that will define, build, and strengthen the unit as it seeks to transform and survive from one set of circumstances to another, whether it be a growing season, a market cycle, a time of life, or a natural disaster. Finance provides the means to bridge uncertain circumstances, such as the costs of discovery, retirement, illness, new technologies, family additions, or a future college education. Innovations that can lower the cost of these objectives are the subject of financial history.

Common to all social units is the need to form a community of interests that can be managed and financed. All households have a division of labor and tasks, management of resources, and a need to sustain itself with cash flow. The same is true for any social enterprise—a company, church, state, railroad, or war. Since Adam Smith's Theory of Moral Sentiments appeared in 1759, those attempting to understand finance have dealt with the human interactions that underpin economic outcomes.

For a community, household, family, or enterprise to balance competing and conflicting claims, it must establish trust to sustain and continue transactions to build toward any common objective. As a moral sentiment and social link, trust embodies and secures a claim. We can trace the genesis of trust as a legal concept to late in the Roman Empire. It was through trusts that ownership and management of property first became possible beyond those lands granted, restricted, or seized by a monarch. In medieval England, when knights set off to do battle or join the Crusades, they entrusted their rights to land and property to the church or bishop, who managed them in their absence. From these arrangements sprouted sophisticated legal measures to preserve family estates and keep them out of the hands of the king. England's trust laws became key instruments of finance, contributing moral, legal, and, ultimately, financial underpinnings that democratized markets.

The point of social interaction, in which monetary resources are allocated to pay for community needs (homes, machinery and equipment, and infrastructure), requires some bond that will hold together and steward the economic resources necessary for the community or enterprise's survival. We can trace references to bonds as covenants that obligate as far back as the early fourteenth century. As codified under English law in the sixteenth century, a bond came to be understood as a deed that binds someone to pay a certain sum of money; the Oxford English Dictionary(OED) cites its early use in 1592 as "a contract whereby any man confesseth himselfe by his writing orderly made, sealed, and delivered to owe anything unto him with whom he contracteth." "Go with me to a notary," says Shakespeare's Merchant of Venice, "seal me there your single bond."

Already by the seventeenth century, bonds had become synonymous with debentures (notes backed by credit). Companies and governments issued them to finance everything from building infrastructure to waging war.

When capital resources are deployed to fund an enterprise's ongoing operations, ownership equity is created. In accounting terms, equity is what remains as the interest in assets after all liabilities or other claims are paid. The underlying premise of equity in this sense implies evenhanded dealing. Colloquially and quite literally, it became something you could count on—a piece of the action, some skin in the game. By the nineteenth century, the notion of equity encompassed a recognizable right or claim, such as a wife's equity to a suitable provision to maintain herself and her children, or the right to redeem an equity claim from a trust for a home or property. Finally, as stock markets became more ubiquitous, equity came to be understood as the stock (or residue) of a company's assets after creditors were paid. The building of equity in a home, business, or any aspect of productive society is the underlying factor driving real growth; this process embodies the value created by social collaboration in a household, company, or industry.

If all these values can be realized through social constructs and codified in binding legal arrangements, security is the ultimate result. When social relationships reinforce bonds, create trust, and build equity in the household, enterprise, or community, the result is greater overall security.

According to the OED, the first appearance of the term security suggesting property deposited or value derived as a legal obligation to secure fulfillment of a financial claim turns up in the sixteenth-century register of the Scottish Privy Council. Shakespeare's Henry IV expressed the vagaries of valuation: "He said sir, you should procure him better Assurance ... he would not take his Bond and yours, he lik'd not the security." By the seventeenth century, land registries mention securities held by creditors as guarantees for right of payment, as well as stocks, shares, or other form of investment guaranteed by security documents. When this system of exchange functions smoothly, the byproduct is the nonfinancial sense of security—that condition of being protected and safe or enjoying freedom from doubt and want.

This brief tour through the pages of the dictionary reflects not only the origins of the words we use in finance: It also illuminates the foundational concepts that inspired early markets and enabled them to work—concepts that are very much alive and at work today.